9 Reasons To Be Bearish On Farmland

This is reprinted (with updates) from the Pro Farmer Annual Land Report, published earlier this fall. Look for our 9 Reasons To Be Bullish On Land in an upcoming issue.

1.Interest rates will rise — eventually.

With interest rates at historic lows, the eventual long-term trend can be in only one direction — up. When that happens, business costs for operating farmers will rise. That will make it more difficult for the number one buyers of farmland — farmers — to generate the cash for land purchases.

In addition, investors who bought farmland because of poor returns on financial instruments will be tempted to rethink their investments when yields on certificates of deposits, for instance, rise to attractive levels.

Recent buyers of farmland may also find it difficult to service debt on purchases if interest rates rise and they do not have their mortgage rate locked in for the long-term and/or do not have enough other equity on their financial statement.

2. Prices at near-record high levels.

The run up in land values the past two decades has carried land prices well above their previous peak, which was posted in the early 1980s.

The chart below is for Iowa, but, it is typical of the price pattern seen in many Midwestern states. The data in the chart is from the annual survey conducted by Iowa State University. It shows an acre of good Iowa cropland reached $5,064 an acre at the end of 2010, up $693 an acre from 2009 and a 16% jump compared to a year earlier.

Market observers believe a sharp run up to record levels normally is followed by a major correction. They don’t view the setback in late 2008 and early 2009 as a major correction. They worry that a correction in land values is

3. Farm program safety net uncertainty is another cause for concern.

Cuts to federal farm program payments are a major risk for land values. That’s especially true for areas that have minimal buying interest for nonagricultural use (other than hunting) such as the western two-thirds of Oklahoma, Kansas, Nebraska, South Dakota and North Dakota. Given the massive size of the federal budget deficit (estimated at nearly $1.3 trillion), talks of potential cuts in federal farm program payments have surfaced. Cuts, if ordered, would prove negative to land values.

Obviously, it is difficult to estimate how much a cut in federal farm program payments would impact land values. But Kansas State Ag Economists Terry Kastens and Kevin Dhuyvetter have attempted to put a number on the potential impact.

In their analysis, they looked at cash rents and land values from 1951 to 1972 to calculate what they termed the agricultural value of farmland. They then applied those results to 2009 cash rents to determine what current land values would have been in a similar "ag-only" environment. They also looked at the average relationship between government payments and cropland cash rents. That relationship is shown in the figures above.

It shows the substantial contribution of federal farm program payments to southern agriculture and in the Great Plains. They suggest another way to look at the percentages in the figures above is to view each state’s percentage figure as the percent cash rents would fall if federal farm program payments were reduced to zero. The impact is remarkable. And if you apply a 4% or 5% cap rate on the lost cash rent income, the impact on potential land value is also quite remarkable. While there is no credible discussion of cutting farm program payments to zero, the impact of any decrease in payments could prove negative on land values.

The amount of actual farm income support offered by the current farm bill is also a major question mark. The bill left price support levels basically unchanged from the previous farm bill. But production costs have moved sharply higher since. Growers worry a decline in grain and soybean prices to farm program price support levels will mean significant operating losses. That would prove to be a major negative on land demand if that were to occur.

4. Declining investment returns.

Even though cash rental rates have risen, the rate of that increase has not kept pace with the rapid run up in land values. According to USDA, the annual return to an average acre of cropland was 4.7% in 2000. By the start of 2010, that return was 3.8%. A similar situation occurred just prior to the collapse in land values in the early 1980s.

5. Changes in tax policy.

Congress passed an extension of the income and capital gains tax cuts passed in the wake of the 9/11 terrorist attack. That spared U.S. citizens from the largest tax increase ever levied in history. However, potential tax increases from both state and local governments to shore up gapping deficits could prove a major drag on the economy and extend the reduced demand for recreational land.

6. Massive budget deficit.

The Congressional Budget Office (CBO) estimates the 2010 fiscal year federal budget deficit will be slightly less than $1.3 trillion, which follows 2009’s staggering $1.4 trillion deficit. The 2010 deficit is equal to nearly 9% of the nation’s gross domestic product (GDP), following 2009’s 10% of GDP. The 2010 budget deficit is the second highest (2009’s deficit was the highest) since 1945.

A deficit this large cannot be ignored. While what will come from the next Congress is still unknown, there’s been much talk of cutting the deficit by reducing spending. While positive in the long run, the immediate impact from reduced spending could prove a damper on the economy.

It’s not just a federal issue. State, county and other local budgets are all under pressure, which is already prompting tax increases at each level. The cumulative effect of these increases could prove very damaging for the economy and could pressure land demand.

7. Ethanol hype is gone.

The industry became a Wall Street darling as the government identified it as a prime weapon in its battle to lower energy prices. Investment capital poured into new construction and corn-hungry plants sprung up throughout the Midwest. The demand from this new industry thrust corn prices higher, which sent land prices higher. Then the break in crude oil and corn prices in 2008 burst the euphoria along with several ethanol companies. Profitability returned in 2009-2010 but the rise in corn prices in late 2010 stretched operating margins thin.

Whether this is the end of the ethanol "boom" or is simply a correction is a matter of debate. But a contraction in ethanol industry demand for corn would have a dampening impact on land demand.

8. Carbon legislative/regulatory uncertainty.

The uncertainty over climate change enforcement from the EPA and any potential "cap-and-trade" legislation mayprove an important damper on land demand long-term. Landowners worry whatever EPA decrees will be negative for agriculture. Same can be said for any potential "capand-trade" legislation. A bill has passed the House, but its fate in the Senate is uncertain. What is known about the House bill is not seen as positive for agriculture and, thus, a negative on land demand.

9. Financial stress in livestock industries.

The beef, pork, dairy and poultry sectors all showed recoveries in 2010 after facing severe financial stress in 2007-2009,but the sharp rise in corn (feed) prices at year end threatens the rebound. If domestic feed demand falls, some of the support for corn prices — thus land values — will weaken as well.